Marcus Brunnermeier
Visiting Fellow Explores Financial Frictions in a New Theory of Money
Careful study of bubbles, mispricings, and financial crises has led Markus Brunnermeier to a new theory of money, which he presented at workshop during his stay as an Visiting Fellow in October.
Brunnermeier and Princeton colleague Yuliy Sannikov have developed a macroeconomic model to explore instabilities in the financial system in a volatile economy. They found that actions of financial managers lead to even greater price declines and market losses.
“Our approach takes the opposite extreme than the new Keynesians; we focus more on the financial frictions instead of price stickiness,” Brunnermeier explains. Market shocks and volatility sets off feedback loop, where falling asset prices reduces demand, which lowers the net worth of the investor.
Leverage amplifies this effect. “In a shock, when asset prices drop, banks facing margin constraints will be forced to sell assets and delever. Their balance sheets will shrink, which hurts the economy even more.
“When the money supply is shrinking, this leads to deflationary pressure, which hurts banks because their debt is now worth more. Banks are hit on the asset side and the liabilities side,” he added.
“This is a departure from the more traditional price stickiness view —that is, that the economic shock means demand is weak, which usually means calls for lower interest rates and increased consumer spending.”
Brunnermeier said this helps explain why the money multiplier collapsed in crises. In the recent crisis, the Federal Reserve backed a huge expansion of the monetary base but M3 did not expand dramatically.
In the paper, Brunnermeier and Sannikov explore what optimal monetary policy should be in response to this deflationary spiral. They also find that while efforts to spread risk through securitization and derivatives does reduce inefficiencies, these actions also amplify systemic risks.